Monday, January 12, 2004

Antitrust News: Smoking Out the Cartels

The FTC likes to compare price-fixing cartels to "smoke-filled room conspiracies." If ever there was an appropriate use of that phrase, it would be the cartel formed by state governments to extort cigarette companies. Last week the Second Circuit considered the latest case to arise from the perpetual "War on Smoking", Freedom Holdings Inc. v. Spitzer. This appeal reinstated a suit brought by tobacco importers against the State of New York. Specifically, the importers challenged the state’s enforcement of the 1998 Master Settlement Agreement (MSA) between 46 states and the nation’s four largest cigarette manufacturers. The MSA purports to compensate states for the healthcare costs incurred from smoking-related illnesses, and restricts the industry’s general marketing and sales practices. The MSA requires manufacturers to make an annual payment to the states based on each firm’s individual market share.

The MSA payments function as an additional tax on cigarettes, since the additional costs are passed on to the consumer. This price increase creates a problem, however, since various small cigarette companies were not parties to the MSA. These companies could conceivably undercut the MSA companies on price, gain market share, and thus decrease the annual payments to the states. To combat this, the states passed laws that require these smaller companies to either join the MSA and abide by its terms, or pay money into an “escrow fund” that effectively taxes the non-MSA companies at a higher rate. The express purpose of these laws is to discourage price competition that would otherwise undermine the states’ ability to realize the maximum revenue possible from the MSA.

New York went one step further. Many non-MSA sellers were not paying into the escrow fund and selling “contraband” cigarettes. Accordingly, New York required all cigarettes sold in the state to bear a tax stamp indicating the manufacturer or importer was complying with the escrow rules. Yes, this is indeed a “stamp tax,” the kind that caused so much trouble when New York was ruled by the British crown. The irony is obviously lost on New York officials.

A group of importers challenged the contraband rule, alleging it violated the Constitution’s Commerce Clause and, of all things, the Sherman Act. The trial court dismissed the complaint on summary judgment. The Second Circuit reversed on the Sherman Act claim, holding that New York’s enforcement of the MSA could very well be an illegal cartel arrangement. Gee, you think?

The truly amazing—and appalling—thing about this case is how New York articulates two completely contradictory objectives. On the one hand, the state claims its protecting public health by enforcing the MSA, which raises the price of cigarettes to discourage consumption; on the other, the contraband laws exist to maximize the state’s revenues from the sale of cigarettes. And keep in mind, the states are under no obligation to use its MSA payments to subsidize public health costs. Most states in fact use the MSA funds for general budget items.

Then there are the lawyers. Most states retained private counsel to represent them in the cases leading to the MSA. When the ink dried on the settlement, these lawyers cashed-in big time. The New York lawyers alone took home more than $600 million. Peter Angelos, the Baltimore Orioles owner and a prominent tort lawyer, tried to claim $1 billion in fees from Maryland. The Kansas attorney general paid millions to her own former law firm. And Texas paid over $3 billion in fees to five lawyers who also happened to be among the top ten political donors in the state.

So what we have here is a giant cigarette cartel that’s being forced to fund the operations of a large alliance of state governments and trial lawyers. How this benefits “public health” is beyond my ability to conceptualize. But I do know this: If ever there was a proper use for the antitrust laws, this is it. Of course, you shouldn’t need antitrust to undo this situation. The state attorneys general and private attorneys who cooked up this scheme should be sitting in prison for committing what is possibly the largest extortion scheme in world history. Since that’s never going to happen, we should focus our efforts on deposing the political leaders who committed these atrocities.